Plan to increase marginal tax by 8.5%

Over at Catallaxy, Sinclair Davidson has mentioned that the government is considering an increase in income tax. Specifically, they have said that they want to increase the Medicare Levy (income tax with another name) from 1.5% up to 2.25%.

But Sinclair misses, along with all the media and public commentators, miss the biggest part of the story.

The proposed reform would mean that all people earning over $22,960 would have their marginal tax rate increased by 0.75%. But … and this is the part not well understood … people earning between $20,934 and $22,960 would have their marginal tax rate increased by 8.5%!

That is a significant increase in the marginal tax rate for people on low-incomes. It should also be noted that if we factor in normal income tax (15%) and loss of welfare benefits (60%), the effective marginal tax rates on somebody earning about $21,000 is about 85%. Poor people need a tax cut, not a tax rise.

The reason for this anomaly is that (contrary to popular perception) the Medicare Levy does not have a flat marginal tax rate. Instead, it is 0% for people earning up to $17,794 and then it is “phased in” at 10% for people up to $20,934, and then there is a marginal tax rate above that of 1.5%.

With the government’s proposed increase to the Medicare Levy, the “phase in” period (ie the 10% tax bracket) will need to be extended to people earning up to $22,960… so that people earning about $22,000 will see their marginal Medicare Levy payment increase from 1.5% up to 10%.

Suffice to say, this is very poor policy.

The sad news is that our tax system is so complex that the media and other commentators have totally missed this massive marginal tax rate increase. If the government directly announced a marginal tax rate increase of 8.5% for some of the poorest people in the country there would be a public outcry. But because they’ve announced it in a way that few people understand, they appear to be getting away with it.

33 thoughts on “Plan to increase marginal tax by 8.5%

  1. On an unrelated note: I was happy to read Sinclair Davidson’s article in the Australian today unapologetically trashing Rudd’s economic “thinking”.

    Back to the post: Sounds like people need to be spreading the word about this 8.5% tax increase.

  2. I presume that this doesn’t include the effects of FTB-A and FTB-B. Also I’m not sure whether SATO is relevant at this income bracket. Plus if we want to look at the total tax burden we should give consideration to the likes of payroll tax and GST.

  3. The media on balance will always find a way to rationalize tax increases like this and play softball. The productive majority need to take the red pill in order to realize in general what kind of motives and mindset the people that produce political media have.

  4. My head hurts. The system sure isn’t streamlined or simple.

    Sounds like the welfare and tax effects really create a big old poverty trap around the $20,000 mark.

  5. I don’t think “poverty trap” is such a good name. Poverty isn’t prevalent in Australia. And such traps exist at all sorts of levels within the system including at some above averge income levels.

  6. Sorry John, but you are TOTALLY wrong.

    There is no ‘10% bracket’. You pay 10% of your income over the phase-in amount. At the moment the people pay 10% what they earn *ABOVE* $17,794. At $20,934 this 10% of the money over $17,795 equals 1.5% of their income.

    Someone who earns $20,000 currently pays ($20,000-$17794)*10% = 220.6, less than 1.5% of their income.

    No one pays 10% of their income in medicare levi. The max you can pay is 1.5%. People on a low income pay 0%. People from 17.7k to 20.9k pay a sliding amount from 0% to 1.5%, this slide is called the ‘10% bracket’ because of the way it is calculated, it is NOT a 10% bracket, its a 0% to 1.5% bracket.

    No one under the new system no one will pay more than 2.25%. There is no way anyones tax margin could have gone up by 8.5% to 10% because the 10% margin does not exist.

  7. The marginal tax rate is the amount of tax you pay on the next dollar of income. John is right, DanD is confused.

  8. DanD — income taxes are nearly universally discussed in terms of the marginal tax rate (meaning: for the next dollar I earn, how much do I give the government).

    The reason for this is that it is the marginal tax rate that determines the work incentives and the efficiency of the tax.

    You are referring to average tax rates. This is a different concept. Unfortunately, you are not alone in mixing up these two concepts… which is why so few people are aware that there is a 10% marginal tax bracket in our medicare income tax.

    To be clear, the following is our medicare income tax marginal tax brackets, reported correctly:

    $0 – $17,794 …….. 0%
    $17,794 – $20,934 … 10%
    $20,934 + ……….. 1.5%

    Unfortunately, the government doesn’t report these correctly, which confuses the majority of commentators (including DanD above) and so they are able to get away with this absurd system.

  9. I agree that the marginal rate went up by 8.5%, but the way he wrote the article he talks is if tax in general has increased by 8.5% or something, because if he isn’t saying that, his post makes no sense anyway.

    Low income earners who fall into the 8.5% marginal increase, their tax amount in total will rise by *LESS* than 0.75%. So the claim that low income earns aren’t being looked after is not true.

    Put it this way – someone has to be on the 10% ramp.

    If he wants to aruge that the ramp shouldn’t be 10% then the change to the medicare has nothing to do with it. And his claiming the policy is bad because people will be on the ramp makes no sense. The ramp already exists and is ‘unfair’ (by his logical) reguardless of if the chance goes through or not.

    I would say to John: How can you possibly ramp to 2.25% margin without exceeding 2.25%? You can’t. Does John think it should be 3% or 4% or 5%? What does he want the marginal rate on the ramp to be? And why does he only want the change in the ramp with this policy change, why not a change in the ramp even if this policy change is rejected?

  10. The only thing ‘absurd’ is the fact that you guys are complaining because the ‘marginal rate’ is not progressive, while the actual rate IS progressive.

    Even if it was made progressive, then the next deriviate would be unprogressive. So you then you would all be claiming that ‘the margin of the marginal rate isn’t progressive’.

    The tax is 1.5%. Its 0% for low income earners. The ramp between these values MUST have a high derivitate (marginal rate). If it doesn’t it must have a high second derivative. If it doesn’t it must have a high third derivative. The whole thing is exercise in pointlessness. How complicated do you want the ramp to be?

    And since when is giving a break to the ‘poor’ a libertarian princible? Shouldn’t be all be arguing that we should all pay 1.5%/2.25% reguardless of income?

    All I am saying is that arguing about the 10% marginal bracket has nothing to do with the rise from 1.5% to 2.25% and shouldn’t effect the policy of this rise in anyway. No one is talking about it in the media because it already exists.

  11. DanD — this is what I wrote: “people earning between $20,934 and $22,960 would have their marginal tax rate increased by 8.5%”.

    I do not say, nor imply, that the average tax rate is increasing by 8.5%. That would be a strange thing to write, because tax is normally discussed in terms of marginal tax rates. And it is a strange thing for you to think.

    You claimed I was “TOTALLY wrong”. As it turns out, I am totally correct and you have confused average with marginal tax rates. That is an understandable mistake to make… but it is generally good form to admit mistakes when they are pointed out.

    You say that “someone has to be on the 10% ramp”. That isn’t true. The government could simply remove the 10% bracket.

    You suggest that I should be against the entire 10% bracket, and not just against the expansion of the bracket. Indeed, that is my position, which I have written about previously. And just because the 10% bracket currently exists, that doesn’t mean it is a good idea to expand it!

    You continue to ask what I want the ramp to be, which implies that a tax system must have a ramp. That simply isn’t true and the vast majority of income taxes don’t have a ramp. There is no reason for you to be making that assumption, and it seems to indicate that you might not be familiar with how income taxes generally work.

    I didn’t complain that the system isn’t progressive, and I would ask you to please not misrepresent me. I complained that the proposal will increase marginal tax rates on some low-income workers by 8.5%.

    As for libertarian principles, the general principle is that people should be free to control their own lives. That includes the rich and the poor. But I don’t think you need to be a libertarian to realise that we shouldn’t be increasing marginal taxes on the poorest workers in society.

  12. I very sorry that I jumped the gun on what you were saying. However you still are claiming that this isn’t fair to low income earners because of the marginal rate.

    These poor people are getting 8.5% marginal rate increase over a few thousand dollars, while at the same time getting a decrease in marginal rate of 1.5% over $17,000+. But you seem to be completely ignoring the decrease.

    You say that the goverment could simply remove the 10% bracket. This is clearly not so. If they removed the 10% bracket right now someone who earns $20,935 would pay $314 as soon as they earn’t another dollar, a marginal tax rate of 31400%.

    You say that most taxes don’t ramp. Again you seem to be comparing apples with oranges. The 15c/30c/etc income tax brackets don’t ramp because people who pass the bracket don’t pay 15c/30c/etc on each dollar earn’t UNDER the bracket once they pass it, they pay the last brackets rate for dollars outside that bracket.

    The situation with medicare is completely different. Once someone passes the $20,934 they not only pay a 1.5% marginal rate, they also have to pay 1.5% on every dollar earned under $20,934. I think you have missed this point. The ramp is absolutely required.

    The whole idea of medicare was that everyone should pay the flat rate of 1.5%. The goverment gives a discount to some people, which results in them paying from 0% to 1.5%. If the ramp was abolished the 1.5% rate would have to increase drematically. If for example people in the 1.5% bracket did not pay 1.5% for the money earned under $20,000 that would cost the goverment about $4 billion and they would have to change the 1.5% bracket to probably 2%. Do you think this is more fair – richer people paying even more than their fair share?

    Face it: removing the ramp can only possibly make the system LESS fair. Not more fair. This is why they are bringing in the same kind of ramps for HECS.

    The only claim that has any merit what-so-ever is that people will be less likly to want to work for a few extra dollars if their marginal rate goes up by 8.5%. However even this is a pretty far-fetched claim. The people in the middle of the 10% medicare bracket are only going to have a marginal rate of about 23%, still way below the average marginal rate of a working Australian at 31.5%.

  13. I appreciate your retraction DanD, and it’s good to see somebody debating in good faith.

    However, unfortunately I have to point out another error. I have not ignored the Medicare Levy tax-free threshold. Indeed, I mention it in my post (“it is 0% for people earning up to $17,794”) and again clearly in comment #8.

    The government could very easily remove the 10% bracket, or at least drop it to 1.5%. Then you would pay 0% on income between $0 and $17,794 and pay a marginal rate of 1.5% on income over $17,794.

    So to use your example of somebody earning $20,934… they would pay 1.5% on $3140 ($20,934-$17,794), which is $47.

    You are correct that the normal income tax scales up with people on higher incomes paying a higher marginal tax rate. Of course people don’t pay their marginal tax rate on dollars earned under the relevant tax bracket.

    You say the Medicare Levy is different. Kinda. The only difference is that the Medicare Levy has high 10% bracket for some low-income earners. But there is no need for that tax bracket.

    You are right that people who earn over $20,934 pay an average tax rate of 1.5%. But there is no god-given rule that says their average tax rate must be 1.5%. Just change it.

    I haven’t missed the point. I understand exactly what the Medicare Levy is trying to do, and I’m pointing out that negative consequence — that it is creating a 10% marginal tax on low-income earners — in the hope that people will change the policy.

    You point out that lowering a marginal tax rate would raise less revenue. Yes, I am aware of this. I often argue that the government should be reducing tax rates. And I certainly argue that the government shouldn’t be increasing marginal tax rates, as they are considering.

    As for how I would design an income tax system (because the Medicare Levy is simply part of our income tax system), that is a big question. But one this is certain, I would not have higher marginal tax rates for low-income workers. I find it hard to believe that anybody thinks that is a good idea. The current marginal tax rates are 0%, 15%, 25%, 16.5%, 20.5%, 35.5%, 31.5%, 39.5%, 46.5%. In my opinion, it is absurd that we have two regressive elements in our tax code, and I’m not sure why you’re defending it. In my opinion, it needs to be changed.

    You say that people on $21,000 will have a marginal rate of 23%. I already addressed this in my original post and I kindly ask you to re-read it more carefully. This is what I wrote:

    “It should also be noted that if we factor in normal income tax (15%) and loss of welfare benefits (60%), the effective marginal tax rates on somebody earning about $21,000 is about 85%.”

  14. Pingback: Healthcare reform « Thoughts on Freedom

  15. I think I have explained myself poorly – the 10% is never seen by anyone. We have a PAYG tax withholding system. This witholds at the net rate for the year, it does not progressively hold at the marginal rate for each dollar earned. Therefore at no point in time does anyone on the 10% medicare bracket pay 10% on any dollar they earn to medicare, instead they pay some amount between 0% and 1.5% of their take home pay. The 10% only matters to calculate the average weekly PAYG amount and to do your tax return at the end of the year.

    This undermines your whole claim that people are getting a high tax rate. In truth they are not – they get a high marginal rate – that has no effect on them – because at no time does a maringal rate actually get taxed to any dollar they earn. Each pay only takes 0% to 1.5% PAYG for medicare – even if they are in the 10% bracket. No person at all can possibly have the full 10% taken from any PAYG. The fact that it goes down from 10% to 1.5% means absolutely nothing because PAYG withheld only goes from 0% to 1.5%. This high tax bracket cannot possibly have any effect on the mentality of people earning another dollar (except for a very very tiny minority who earn in the 10% tax bracket and are considering if or not to work a day or two over-time near the end of the financial year).

  16. DanD – If somebody working a three day week (say Wednesday – Friday) is on a weekly wage of $346 and they are asked to work one Saturday then the wage on that Saturday is going to be taxed at a rate of 10% in regards to medicare. Assuming that they know this then they have a slighly reduce incentive to accept the overtime.

  17. DanD — you are still wrong. There are people who face the 10% medicare levy bracket. You’re still confusing average tax with marginal tax.

    This is a common mistake for people who don’t understand how tax works, but I’ve already explained this to you several times and I’m not going to explain it again. I recommend doing some of your own research on the concept of effective marginal tax rates.

  18. Thanks, but I know what it is. I was just making the point that with PAYG the fact that PAYG starts taking 1.5% before $22k (it starts at $10k infact) that the marginal rate is spread and most people will not see it. Indeed what TerjeP says is wrong, because the PAYG brackets specifically are alligned so that 1.5% comes out before the $17k is reached, so that 10% never has to come out for each dollar. The 1.5% starts at $10k so in the payg the marginal rate for medi never goes above 3%, not 10%. This also ensure they get a small tax refund.

    I don’t deny that someone on $22,000 will have 8.5% less incentive to get more money. But I do say that the since the total amount increases by so little, and that they pay the 8.5% increase spread out over the year, its very unlikly anyone will factor it into their decision to accept more work or a higher paying job.

    I still say that someone being moved onto the 10% bracket is getting a discount – they get less of an increase than the reset of us. They get to pay 10% of a tiny portion of their income, while everyone else pays 2.25% of their entire income – which ends up being more.

    I mean the only thing that can come from all this is that we shouldn’t give the people 0% to begin with, because they will then face a ‘mental’ bridge of having to pay it back the low income discount we give them if they earn more money. Seems like a pretty selfish way for these people to see it.

    I conceed that you are right and some people will probably work less, but those who do will see it as getting 1.5% extra per week in their pay check rather than getting 10% extra per week on their last few dollars. And that the real increase these people will consider is the 0.75% across their full income, not the 8.5% on their last few bucks. Regards, dan.

  19. If we ditched the medicare levy entirely then it would all be a heck of a lot more transparent. Whilst we are at it we should ditch the LITO.

  20. PAYG (LITO adjusted) starts for people on $15,000 per year, at 15%. Below that they pay $0 income tax.

    Medicare Levy starts for people on $17,794 per year, at 10%. Below that they pay $0 Medicare Levy.

    For a person earning $20,000 they are currently facing an effective marginal tax rate of 85%. For somebody on $21,000 they are currently facing an effective marginal tax rate of 76.5%. The government is considering increasing their effective marginal tax rate up to 85%. That is a bad idea.

    A person having their marginal tax rate increased by 8.5% is not getting a discount. What they are getting is a higher marginal tax rate. There is a wealth of evidence that shows that higher marginal tax rates lead to lower incentives to work. Indeed, the deadweight loss from this effect is measured to be around 20-40% (meaning each dollar of tax creates $0.20 to $0.40 economic loss).

    I find it very strange that you call these people “selfish” because they notice that they have an 85% EMTR!

    Note that what matters is the marginal tax rate. Not the average tax rate.

    You still seem to be stuck in the idea that you must have a constant average tax rate. That simply isn’t the case, and the vast majority of income tax systems aren’t like that.

    ===========

    Terje — an easy first step would simply be to report the actual marginal tax rates and stop with the misleading approach of reporting PAYG, Medicare Levy & LITO separately. Once they are reported honestly, and once people understood the system, I think there would be strong support for reform.

    After all, who would sit down and intentionally create a system of 0, 15, 25, 16.5, 21.5, 35.5, 31.5, 39.5, 46.5%…

  21. John – given your last sentence that “easy first step” isn’t so easy politically. I think you would need to incorporate and change at the same time.

    Do you have the complete tax tables with LITO and medicare integrated including rates and thresholds in a before and after scenerio given the governments proposed changes to medicare? In other words the rates and the thresholds. If you do I’d be happy to pretty them up in a table like I did with the LITO numbers previously.

  22. Humphreys: where does the 76.5% come from? What welfare do they loose?

    IMO the yo-yo brackets are a way they can legitimize medicare, which is not tired to health costs at all.

    The yo-yo marginal rates are used because otherwise the wealthy would have to be given the same tax-free thresholds as the poor. This would result in those thresholds being lowered, or the taxes on the upper brackets being riased (which would cost votes!).

  23. The 76.5% comes from 60% withdrawal of Newstart allowance (the dole) plus 15% marginal income tax, plus 1.5% marginal medicare levy.

    When you add the proposed 8.5% increase in the marginal medicare levy, that goes up to 85%.

  24. I’m not sure how these numbers are being calculated. The EMTR for a single Newstart allowance recipient (assuming they are under 55) @ $20,000 is currently 66.6%. Thats on the next $1 of private income. It’s made up of 60% Newstart withdrawal, 6% tax and 0.6% medicare. You can’t just add 60% and 15% and 1.5% – the tests don’t stack together in that way. At least not in the theoretical world of EMTRs.

  25. More the point where the heck do you get the marginal impact of tax as being 6%.

    Spog – you are way off.

  26. Nope, those numbers are spot on.

    You guys aren’t taking into account that the 60% taper on Newstart means that each $1 of PRIVATE income results in only a 40 cent increase in taxable income. So, each $1 increase in private is taxed at 40% of 15%, and “medicared” at 40% of 1.5%

    Your numbers would be right if Newstart wasn’t assessable income for taxation purposes, but it is. Your tax rates would be okay on their own, but you’ve dragged Newstart into the mix. A whole new world.

  27. Spog – my apology. What you are saying does actually make sense.

    Somebody earning $20000 including Newstart who then earns an extra private dollar in income will after the Newstart withdrawal rate have a taxable income of $20000.40 as you suggested. So the applicable tax rates will effect the 40 cents only.

  28. No apology required Terje, especially after I crank up the pedant-ometer a little, and say that your comment is still not quite on the money (or EMTR in this case).

    I was referring to a person with a private income of $20,000. Your last comment refers to a person with a taxable income of $20,000, including Newstart. Such a person would have (under current rates) a private income of around $16,895, plus taxable Newstart of $3105. With that combination making up the $20,000 taxable income, the EMTR on the next $1 will be 70%. This comprises the 60% Newstart taper, plus 40% of the tax and medicare rates. However at this income the person is still inside the medicare levy shade-in of 10% so the total tax/medicare is 25%, and 40% of that is 10%, for a total EMTR of 70%.

    I’d put up an EMTR components picture to show what’s interacting with what to make up the EMTR over (say) a $0 to $30,000 range, but alas that’s not really feasible in a blog comment.

  29. Spog – yes I later thought about this again and I agree the medicare rare is higher. It is a bugger of a system to navigate. However your key point that income taxes only apply to the part of the dollar that remains after the welfare phase out (assuming the welfare dollar is taxable) is a key insight and one that John and I both missed. So thanks for taking the time to explain this.

  30. “I’d put up an EMTR components picture to show what’s interacting with what to make up the EMTR over (say) a $0 to $30,000 range, but alas that’s not really feasible in a blog comment.”

    Ah, but you can do guest blog post 😀

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